Takatoshi Kato, IMF Deputy Managing Director receives interview from Yong Tang, People's Daily correspondent based in Washington D.C.

China should shift public expenditure to higher spending on health and education and reforming the pension system in order to encourage domestic consumption, said Takatoshi Kato, IMF Deputy Managing Director, in a recent exclusive interview with Yong Tang, People's Daily correspondent based in Washington DC. Kato also said in the interview that the IMF is doing less and less firefighting type of work while IMF's job as a doctor practicing preventive care is getting more and more prominent.

Yong Tang: Chinese currency is a hot topic today in China as well as in the world. What is the IMF view of the revaluation of Chinese currency?

Kato: The July 21st reforms last year, including the revaluation of the Renminbi and the subsequent changes, including the January measures that introduced the market maker system in the Shanghai foreign exchange market, were significant steps. These reforms, in our view, have the potential to allow market forces to play a more substantial role in determining the exchange rate. At the same time, the Renminbi remains tightly managed. Following the July 21 2% revaluation, the dollar-Renminbi bilateral rate has appreciated by only a little more than 1%. Also, in terms of the real effective exchange rate- and this is monthly average numbers- from (last) July to (last) December the Renminbi appreciated by 2% in real effective terms. But from (last) December to (this) May the Renminbi depreciated by 3.8% in real effective terms. So in real effective terms the Rrenminbi is where it started in last July.

Also in terms of the dollar-Renminbi bilateral exchange rate, the degree of variability in the Renminbi's pace of appreciation vis a vis the dollar has been quite limited. The daily variability is much less than the 3% range. Also, its rate of appreciation since July is a little bit over 1%. And so in our view the Chinese authorities had better utilize more fully the flexibility provided by the current exchange rate system to allow greater variability of the Renminbi against all currencies. This is in China's interest.

Why is this in China's interest? Because from the near term perspective Renminbi appreciation will create more room to allow interest rates to rise. A rise in interest rates is needed to reduce the large amount of liquidity in the banking system resulting from speculative capital inflows. From the medium-term perspective, greater appreciation of the Renminbi will help to sustain China's growth by rebalancing that growth itself toward more consumption and away from exports and investment. That is in line with the Chinese authorities' objectives of rebalancing growth better.

Yong Tang: Since after last July the Chinese currency has been rising all the time.

Kato: But we need to consider against the extent of China's current account surplus or against its foreign exchange reserves. And as I said, we need to consider the real effective exchange rate.

Yong Tang: What kind of role IMF will play in coordinating China's currency policy in the future?

Kato: As you know, the IMF conducts bilateral surveillance and multilateral surveillance. The foreign exchange rate regime is an important part of IMF surveillance. Because of the increased degree of interlinkage among member countries, there is an increased recognition by Fund members that the foreign exchange rate issue should be given more prominence in the surveillance exercise.

So currently the IMF is looking into various ways in which the foreign exchange regime issue can become a more important part of our surveillance exercise. The Renminbi certainly will be an important aspect of IMF Article IV surveillance of China. In the coming weeks China's Article IV consultation will be taken up by IMF's Executive Board. That is a good indication for the IMF Executive Board to make an assessment of Renminbi as a part of the IMF Article IV consultation framework.

(Article IV consultations usually take place once a year. IMF economists visit the member country to gather information and hold discussions with government and central bank officials, and often private investors and labor representatives, members of parliament, and civil society organizations. Upon its return, the mission submits a report to the IMF's Executive Board for discussion. The Board's views are subsequently summarized and transmitted to the country's authorities. Currently, nine out of ten member countries agree to publication of a Public Information Notice (PIN), which summarizes the staff's and the Board's views, and four out of five countries agree to publication of the staff report itself.)

Yong Tang: What lessons and experiences can China draw from the revaluation of the Japanese currency during 1980s?

Kato: There are two lessons in my view. One lesson is that the private sector or the manufacturing sector is more resilient than I think Japanese authorities thought at that time. After going through a series of appreciations of the Yen, the Japanese manufacturing sector's competitive strength today is not in bad shape. As a matter of fact there is a significant difference in the productivity increase between the Japanese manufacturing sector and the nontradeable-goods sector. After going through a series of revaluations, if anything, the Japanese manufacturing sector's competitiveness has been solidified. On the other hand, the nontradeable-goods sector is less subject to international competition, so productivity increases have been more limited.

The second lesson is that counter-cyclical stimulative monetary and fiscal measures in order to mitigate adverse effects of appreciation shouldn't be carried to an excessive extent. In looking back I think the very loose continuation of the monetary policy stance laid the basis for subsequent accumulation of asset bubble that became evident in the 1990s.

Yong Tang: How can China change from export-based economy to a domestic consumption-based economy? It is a big challenge for China today.

Kato: I share the challenge. By way of checking data, this is the data of China's expansion side. In 1980, the year immediately after the 1978 reform initiative, the ratio of household consumption to GDP was 51%, whereas the latest 2005 ratio of household consumption declined to 39%, the ratio declined by over 10 percentage points. On the opposite side, investment and net exports' share in GDP combined increased by 15-percentage point. So there is a need to rebalance the composition of growth away from investment and exports into more consumption. But as you said, this is an important medium to long-term policy agenda that requires policy changes on many fronts. I can cite some of the policy agenda.

One aspect is shifting public expenditure to higher spending on health and education and reforming the pension system. Those changes shifting the relative weight of public expenditure certainly will work in the direction of the need for household savings because you need to be less concerned about your medical care and education, so households are more willing to spend.

The other aspect is making profitable state-owned enterprises pay dividends to the government. That I think will lessen state-owned enterprises excessive investment. And from the state's point of view I think the additional fiscal revenue can be channeled to education and health care and those other worthy causes.

Another aspect is financial market reform - to see to it that the interest rate mechanism will work, and that enterprises have the alternative of going to the capital market to raise funds. That would make enterprises' investment decisions more efficient. Availability of various financial investments would mean that households could earn better income out of financial investment.

Also I think greater exchange rate flexibility should help in rebalancing the growth pattern into more consumption orientation. In the near term greater exchange rate flexibility is likely to result in the appreciation of the Renminbi. That would, I hope, raise the real purchasing power of households. Households can afford to do more consumption.

Yong Tang: What sort of role will the IMF play in the global economy in the future?

Kato: My response is a bit long. IMF is a unique institution in the sense that it has global and universal membership. Each and every member subscribes to the capital of the IMF. Each and every member country is a shareholder of the Fund. That means member countries have a stake in making sure that the Fund delivers its entrusted mandate. One recent important aspect of that reassessment of the Fund's mandate is what we call the [Medium-Term] Strategic Review exercise. That was undertaken for the [2006] Spring Meetings, and in the September annual meeting in Singapore, the implementation of Medium-Term Strategic Review will be an important agenda item.

There is a sense that each IMF member's house is better designed and better managed. A number of emerging market economies are now equipped with a good sprinkler system. That means a sufficient amount of foreign exchange reserves. So that probably means there is less frequent need for the Fund to do firefighting type of work. Because this is a global community, it is less frequent, but there still will be a need for the Fund to do firefighting job. The question right now is whether the Fund has a sufficient tool kit to do the adequate firefighting job.

One issue the Fund is now looking into is an additional [financing] facility to assist emerging market countries so that they will be less prone to be subject to capital account crises. A less frequent need for firefighting means the IMF's job as a doctor practicing preventive care is getting more prominent. What does preventive care mean? It means coming up with the right diagnosis of member countries' economy and coming up with the right prescription when member countries face challenges. Also, the Fund might be pulled into a preventive care exercise regarding issues that the community as a whole is facing.

In the analogy to medical care, one appropriate example is the Fund's involvement in Avian Flu. The Fund has been advising member countries in what way the member countries can be prepared to cope with the repercussions of a potential Avian Flu pandemic. This means preventive care of member countries, preventive care for the community as a whole. That can be translated into strengthening of IMF surveillance exercise - bilateral surveillance and multilateral surveillance.

As a part of multilateral surveillance, IMF shareholders have given the Managing Director a mandate to undertake multilateral consultations. It's a framework to undertake consultations on specific issues, inviting member countries most relevant in that area to participate. One concrete example is the IMF's multilateral consultation to address the issue of global imbalances. If unattended, increasing global imbalances could result in sudden, very significant changes in asset prices and changes in exchange rates, or changes in interest rates. To do multilateral consultations to address the issue of global imbalances, relevant players - China, the euro area, Japan, Saudi Arabia and the United States - have agreed to take part in the multilateral consultation. That is a very important new undertaking about to go through.

Yong Tang: Firefighting job will be more and more replaced by preventive care job. Do you think IMF could change successfully from one role to another?

Kato: To adapt itself to meet the changing emphasis from a firefighting-type of job to giving higher priority to conducting bilateral and multilateral surveillance, that is the task the Fund will face in the coming years. One consequence likely to emerge is the IMF will depend less on income from lending. The IMF needs to depend more on stable and predictable sources of income. For the immediate month, the IMF's overall financial position includes financial reserves of nearly 9 billion dollars. That is adequate to finance a continuation of its mandate. At the same time, we at the IMF are keen on making sure that Fund activities are conducted in a lean and effective way on the expenditure side. As a matter of fact, the Executive Board approved a medium-term budget framework which provides for a real reduction in administrative expenditures over the next three years.

The IMF at the same time has looked into various new approaches. One concrete example is the activation of the investment account through which more active management of IMF reserves can be explored. We should also look at user fees for some of our services. Those are some of the aspects the IMF has been looking into, or the IMF Executive Board has agreed to implement. But beyond that, there is a need to identify stable and predictable sources of income. This exercise will require political consensus and will take time to help catalyze this process The Managing Director has announced the appointment of an External Committee to make recommendations. Governor Zhou [Xiaochuan] of Peoples Bank [of China] is one important member of that committee of prominent persons.

Yong Tang: Everybody knows America is trying to press Chinese authority to appreciate Chinese currency. America is also an important player at IMF. So to what extent do you think IMF will yield to pressure from American side?

Kato: From the IMF's point of view, the immediate issue is how the IMF can address the issue of growing global imbalances. That is the agenda item for the first round of multilateral consultation. There is a consensus that each participant needs to play a role. The areas that the United States or China or Japan or the euro area need to look into have been identified, and there is a consensus on the necessary direction. So taking up the question of global imbalances, what the cooperative mechanism is that facilitates each participant addressing its own agenda is an area of immediate interest for the Fund.

Yong Tang: How many times have you visited China?

Kato: Many times. Each year after I joined the IMF I paid a visit to China. In 2004 I visited Beijing and Hainan. Last May I visited Beijing, Shanghai and Tianjin. I plan to pay a visit to China at least once every year. Before joining the Fund I visited China. Altogether I have visited China more than 10 times.

Yong Tang: That is a lot. What is your personal impression on Chinese economic development? What strikes you most?

Kato: What strikes me most is that when we talk about IT and we use expressions like Year of the Dog or Year of the Rat, my impression is the Year of the Rat: the transformation is very drastic and very fast. Each time I visit I come across a different China. It's a very fast and very drastic change. (END)

Bio:

Mr. Takatoshi Kato assumed office as Deputy Managing Director of the International Monetary Fund on February 2, 2004.

Born in 1941, Mr. Kato has a B.A. from Tokyo University (1964) and M.P.A. from Princeton University (1968). Prior to taking up his current position, he was Advisor to the President, Tokyo-Mitsubishi Bank and a Visiting Professor at Waseda University. He was also a Visiting Professor at Princeton University (1998-99).

Mr. Kato has held a series of senior positions at the Ministry of Finance of Japan. These include Vice-Minister of Finance for International Affairs (1995-97) and Director-General of the International Finance Bureau (1993-95). From 1985-87, Mr. Kato served as Executive Director for Japan at the Asian Development Bank (ADB). Previously, he held positions at the Ministry of Finance and the OECD Secretariat. Mr. Kato has served as a member of various advisory panels including the World Health Organization's (WHO) Commission on Macroeconomics and Health (2001) and an ADB panel on poverty reduction in Asia and the Pacific (1999-2000). In 2002, he published a book on exchange rate policy. (END)

By Yong Tang, People's Daily correspondent based in Washington D.C.